08/16/2016

Douglas Battista Answers Accounting Questions

Few assets last forever, according to business expert Douglas Battista. While there are many foundational principles of accrual accounting, perhaps the most frequently misunderstood concepts are amortization and depreciation. Battista clarifies the two and offers insight on their practical application in the following Q & A.

Q: What is amortization?

Douglas Battista: Amortization is the method by which accountants spread an intangible asset’s cost over its anticipated useful life. For example, an inventor owns a patent on a piece of sports equipment. The patent itself has a “life span” of 20 years. The costs associated with manufacturing that equipment is divided across each year the patent is active. Each portion is recorded on the company’s income statement as an annual expense.

Q: How is that different from depreciation?

Douglas Battista: Depreciation refers to the process of prorating a tangible asset’s cost over its expected lifetime. You will hear the term depreciation often used to describe automobile value in terms of age and condition. A car that cost $20,000 brand-new is not going to resell for that much in 10 years. The difference between the initial cost and what the vehicle is worth at the end of its anticipated lifespan is its depreciated value.

Q: Are these valuation methods similar to the idea of depletion?

Douglas Battista: Intangible assets cannot be depleted and items that depreciate are not necessarily finite, as they can be repaired and continue to remain useful for an indefinite period of time. An example of a commodity that is subject to depletion is oil. An oil well only has a set amount of oil before its usefulness is gone and a new well must be dug to obtain additional product. The depletion value is based on the initial setup costs spread out over the presumed productive life of the well.

Q: Why is it important to stretch costs over the life of a product?

Douglas Battista: Business owners and investors need to make sure they are going to be able to make a profit. Understanding how much their investment is going to cost them in terms of a yearly expense will help them budget properly and ensure they are making a smart financial decision.